Internal Assignment Financial

Management
Internal Assignment
Financial Management

Submission Date: 9
th
November 2012
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-uestions For internal Assignment
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SRI RAM COLLEGE OF COMMERCE (DELHI UNIVERSIT!
Internal Assignment Financial
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1. What is perpetual bond, debt, types and characteristics with examples from India as well as
in the World?
2. The -factor, its explanation and implication.
. !ree !loat "apitali#ation
$. "%% and %epo %ate.
(!$(!UA. B#ND/ D!B/ "(!S 0 12A$A!$ISI1S
3hat is a 4er4etual bon56
& perpetual bond is a bond with no maturity date. 'erpetual bonds are not redeemable but pay
a steady stream of interest fore(er. Their cash flows are therefore that of perpetuity. 'erpetual
bonds are those in which the in(estor does not ha(e an option to as) for the money bac). *+ut in some
cases, the issuers ha(e the ri,ht to paybac) in(estors and redeem the bonds after a period of time-. &
perpetual bond is collo.uially )nown as a 'erpetual or /ust a 'erp.
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Internal Assignment Financial
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The concept of a perpetual bond is not new. The +ritish Treasury issued one of the oldest
examples of this type of bond at the time of the 0apoleon Wars in the early years of the 11th
century. Today, the ,o(ernment of the 2nited 3in,dom continues to issue a type of this bond
)nown as a consul. &s was true in the past, the format for a perpetual bond is usually that of
acallable bond, althou,h some are not called for a number of years.
&s with most types of bond issues, a perpetual bond tends to be a relati(ely stable in(estment
that will continue to pro(ide small amounts of profit for as lon, as the bond is acti(e. This
ma)es the bond an attracti(e option for in(estors who tend to be (ery conser(ati(e. 4owe(er,
a perpetual bond is ne(er li)ely to yield a hu,e profit in a short period of time, characteristic
that will turn off in(estors who are more willin, to assume ris) in return for the chance to
reali#e a hi,her return.
Some salient 7eatures o7 4er4etual bon5
'erpetual bond issues are .uasi-e.uity, which .ualify as Tier-I capital in India. They are ha(in, the
.ualities of both bonds and e.uities. 5i)e bonds, they pay periodical interest to in(estors. &nd li)e
e.uity shares, they do not ha(e any maturity. That is why they are alternati(ely called as hybrid
instruments. 6uch instruments are fit to .ualify as Tier I capital in (iew of the fact that they had no maturity
date.
2o8 are 4er4etual bon5s 4rice56
6ince perpetual bond payments are similar to stoc) di(idend payments - as they both offer some
sort of return for an indefinite period of time - it is lo,ical that they would be priced the same way. The
price of a perpetual bond is therefore the fixed interest payment, or coupon amount, di(ided by
some constant discount rate, which represents the speed at which money loses (alue o(er time
*partly because of inflation-. The discount rate denominator reduces the real (alue of the nominally fixed
coupon amounts o(er time, e(entually ma)in, this (alue e.ual to #ero. &s such, perpetual bonds, e(en thou,h
they pay interest fore(er, can be assi,ned a finite (alue, which in turn represents their price.
3h9 the su55en interest in them6
The ,o(ernment does not loo) too )een in pumpin, in fresh capital ri,ht now and as the
economy is expandin, ban)s will need more capital. &ccordin,ly, alternati(e forms of capital raisin, would
be re.uired in the form of hybrid capital. 'erpetual bonds were used durin, the 1178s for recapitali#ation of
public sector ban)s and were discontinued since 111$. 6ome of the ban)s that returned capital to the
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SRI RAM COLLEGE OF COMMERCE (DELHI UNIVERSIT!
Internal Assignment Financial
Management
9o(ernment ha(e already shed these perpetual bonds. %aisin, capital throu,h other a(enues such as e.uity
hurts the return on e.uity.
3ho 8ill invest in them6
They are an attracti(e option to lon,-term in(estors such as pro(ident funds and insurance
companies. In a bid to impro(e return on in(estments, pro(ident funds *'!- and insurance companies ha(e
be,un par)in, funds in perpetual bonds floated by ban)s.
2ave an9 In5ian ban:s raise5 4er4etual bon5s6
Two ban)s ha(e recently issued perpetual bonds in Indian %upees, Indian :(erseas +an) and 2": +an).
I:+ in ;arch 288< raised %s 288 crore throu,h an issue of =perpetual bonds,> the first ban) to use this means
of fundin,. These bonds carry an interest rate of 1. per cent, payable e(ery half year. ?arashaw @ "o, a
;umbai-based securities firm, had in(ested %s 288 crore in Indian :(erseas +an)*I:+-,
pic)in, up the entire offerin, of perpetual bonds issued. 2": +an) raised capital to the tune of %s. 28 crore
by issuin, Inno(ati(e 'erpetual ?ebt Instruments ran)in, for tier -I capital and another amount of %s.
A88crore by issuance of bonds ran)in, for upper tier -II "apital durin, the .uarter
ended8.<.288<. In both cases, the bul) of the subscribers were insurers and pro(ident funds.
Tata 6teel 'erpetual +onds were open for subscriptionB the offer closed on 17th Culy 2812,
and at a minimum in(estment si#e of %s. 11.$2 la)hs.
In 288< I"I"I +an) arran,ed D 2A8 million from o(erseas (ia perpetual bond.
'20C&+ 0&TI:0&5 +&03 in 2881 arran,ed 88 crore of fund from perpetual bond.
$is:s o7 investor in 4er4etual bon5
+an)s, %eser(e +an) of India, institutional in(estors - all a,ree that perpetual bonds carry bi,,er ris), for
in(estors, than subordinated bonds. +ut that has not stopped credit ratin, a,encies from
offerin, hybrid capital the same ratin, as that for subordinated debt issued by the ban)s. %+I has
put a ca(eat that such hybrid securities will cease to pro(ide returns if the issuin, ban)>s "%&%
falls below re,ulatory re.uirements *at present nine per cent-.This ma)es perpetual debt instruments a
ris)y option for in(estors, particularly in those ban)s where the "%&% is at lower le(els. What is
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SRI RAM COLLEGE OF COMMERCE (DELHI UNIVERSIT!
Internal Assignment Financial
Management
thus, prima facie palpable is the fact that the >inno(ati(e> instruments hold ,ood only for those ban)s that
ha(e a hi,h credit ratin, and ,ood asset .uality. Else, con(incin, in(estors about the security of their
capital or ,arnerin, the perpetual debt sat feasible interest rates will pro(e to be a complex barrier
for ban)s> capital expansion. The %+I e(idently has thus ensured that while deser(in, ban)s
ha(e sufficient leeway to fund their ,rowth, the inept ones either shape up or ship out, a(er some analysts.
he9 5o not having an9 ta; incentive'
F$!! F.#A 1A(IA.I<AI#N
?efinition
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Internal Assignment Financial
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!ree-float ;ethodolo,y refers to an index construction methodolo,y that ta)es into
account only the free-float mar)et capitali#ation of a company i.e. shares issued by the
company that are readily a(ailable for tradin, in the mar)et. It ,enerally excludes
promoters> holdin,, ,o(ernment holdin,, strate,ic holdin, and other loc)ed-in shares that
will not come to the mar)et for tradin, in the normal course. The effecti(e result of the
abo(e methodolo,y is that each companyFs mar)et capitali#ation in the mar)et is e.ual to
its number of shares floatin, in open mar)et multiplied by its price.
e., %eliance industries has free flow capitali#ation of 1. la)h crore, Infosys has free
flow capitali#ation of 11<<1 crore.
The more the percenta,e of share in the company the lesser will be the free flow
capitali#ation of the company.
&ccordin, the +6E, any shares that ?: 0:T fall under the followin, criteria, can be
considered to be open mar)et sharesG
4oldin,s by foundersHdirectorsH ac.uirers which has control element
4oldin,s by personsH bodies with Icontrollin, interestI
9o(ernment holdin, as promoterHac.uirer
4oldin,s throu,h the !?I %oute
6trate,ic sta)es by pri(ate corporate bodiesH indi(iduals
E.uity held by associateH,roup companies *cross-holdin,s-
E.uity held by employee welfare trusts
5oc)ed-in shares and shares which would not be sold in the open mar)et in normal
course.
A5vantages
& !ree-float index reflects the mar)et trends more rationally as it ta)es into consideration
only those shares that are a(ailable for tradin, in the mar)et.
!ree-float ;ethodolo,y ma)es the index more broad-based by reducin, the concentration
of top few companies in Index.
& !ree-float index aids both acti(e and passi(e in(estin, styles. It aids acti(e mana,ers by
enablin, them to benchmar) their fund returns (is-J-(is an in(estible index. This enables
an apple-to-apple comparison thereby facilitatin, better e(aluation of performance of
acti(e mana,ers. +ein, a perfectly replicable portfolio of stoc)s, a !ree-float ad/usted
index is best suited for the passi(e mana,ers as it enables them to trac) the index with the
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Internal Assignment Financial
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least trac)in, error.
F#$MU.A
Kalue of an index can be calculated as
Index L !ree float mar)et capitali#ation H base mar)et capitali#ation M base index
(alue
Summar9
3hat: The Nfree floatO of a listed company denotes shares that are actually
a(ailable for day-to-day tradin,.
2o8: !ree float can be estimated by analy#in, the shareholdin, pattern, as
published in the annual report or .uarterly information submitted to stoc)
exchan,es and announcements made from time to time.
3h9: !ree float has an impact on prices because it affects stoc) li.uidity.
5atest !ree flow mar)et capital of 6ome of the companies of +6E *on closin, of P
th
0o(ember 2812-
IT" 22P171 crore
%eliance Industries 121$$ crore
4?!" 122P12 crore
Infosys Tech 11<<1 crore
5@T 118 crore
4?!" +an) 18$87 crore
I"I"I +an) 71$11 crore
:09" P828< crore
2! =>FA1#$/ IS !?(.ANAI#N AND IM(.I1AI#N
?efinition of >+eta>
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Internal Assignment Financial
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& measure of the (olatility, or systematic ris), of a security or a portfolio in comparison to
the mar)et as a whole. +eta is used in the capital asset pricin, model *"&';-, a model
that calculates the expected return of an asset based on its beta and expected mar)et
returns. &lso )nown as Ibeta coefficientI.
+eta is calculated usin, re,ression analysis, and you can thin) of beta as the tendency of a
security>s returns to respond to swin,s in the mar)et. & beta of 1 indicates that the
security>s price will mo(e with the mar)et. & beta of less than 1 means that the security
will be less (olatile than the mar)et. & beta of ,reater than 1 indicates that the security>s
price will be more (olatile than the mar)et. !or example, if a stoc)>s beta is 1.2, it>s
theoretically 28Q more (olatile than the mar)et.
;any utilities stoc)s ha(e a beta of less than 1. "on(ersely, most hi,h-tech 0asda.-based
stoc)s ha(e a beta of ,reater than 1, offerin, the possibility of a hi,her rate of return,
but also posin, more ris).
Investing
+y definition, the mar)et itself has a beta of 1.8, and indi(idual stoc)s are ran)ed
accordin, to how much they de(iate from the macro mar)et *for simplicity purposes, the
6@' A88 is sometimes used as a proxy for the mar)et as a whole-. & stoc) whose returns
(ary more than the mar)et>s returns o(er time can ha(e a beta whose absolute (alue is
,reater than 1.8 *whether it is, in fact, ,reater than 8 will depend on the correlation of the
stoc)>s returns and the mar)et>s returns-. & stoc) whose returns (ary less than the mar)et>s
returns has a beta with an absolute (alue less than 1.8.
& stoc) with a beta of 2 has returns that chan,e, on a(era,e, by twice the ma,nitude of the
o(erall mar)et>s returnsB when the mar)et>s return falls or rises by Q, the stoc)>s return
will fall or rise *respecti(ely- by <Q on a(era,e. *4owe(er, because beta also depends on
the correlation of returns, there can be considerable (ariance about that a(era,eB the
hi,her the correlation, the less (arianceB the lower the correlation, the hi,her the (ariance.-
+eta can also be ne,ati(e, meanin, the stoc)>s returns tend to mo(e in the opposite
direction of the mar)et>s returns. & stoc) with a beta of - would see its return decline 1Q
*on a(era,e- when the mar)et>s return ,oes up Q, and would see its return climb 1Q *on
a(era,e- if the mar)et>s return falls by Q.
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Internal Assignment Financial
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4i,her-beta stoc)s tend to be more (olatile and therefore ris)ier, but pro(ide the potential
for hi,her returns. 5ower-beta stoc)s pose less ris) but ,enerally offer lower returns.
6ome ha(e challen,ed this idea, claimin, that the data show little relation between beta
and potential reward, or e(en that lower-beta stoc)s are both less ris)y and more
profitable *contradictin, "&';-. In the same way a stoc)>s beta shows its relation to
mar)et shifts, it is also an indicator for re.uired returns on in(estment *%:I-. 9i(en a
ris)-free rate of 2Q, for example, if the mar)et *with a beta of 1- has an expected return of
7Q, a stoc) with a beta of 1.A should return 11Q *L 2Q R 1.A*7Q - 2Q--.
2ere is a basic gui5e to various betas:
Negative beta - & beta less than 8 - which would indicate an in(erse relation to the
mar)et - is possible but hi,hly unli)ely. 6ome in(estors used to belie(e that ,old
and ,old stoc)s should ha(e ne,ati(e betas because they tended to do better when
the stoc) mar)et declined, but this hasn>t pro(ed to be true o(er the lon, term.
Beta of 0 - +asically, cash has a beta of 8. In other words, re,ardless of which way
the mar)et mo(es, the (alue of cash remains unchan,ed *,i(en no inflation-.
Beta between 0 and 1 - "ompanies with (olatilities lower than the mar)et ha(e a
beta of less than 1 *but more than 8-. &s we mentioned earlier, many utilities fall in
this ran,e.
Beta of 1 - & beta of 1 represents the (olatility of the ,i(en index used to represent
the o(erall mar)et, a,ainst which other stoc)s and their betas are measured. The
6@' A88 is such an index. If a stoc) has a beta of one, it will mo(e the same
amount and direction as the index. 6o, an index fund that mirrors the 6@' A88 will
ha(e a beta close to 1.
Beta greater than 1 - This denotes a (olatility that is ,reater than the broad-based
index. &,ain, as we mentioned abo(e, many technolo,y companies on the
0&6?&S ha(e a beta hi,her than 1.
Beta greater than 100 - This is impossible as it essentially denotes a (olatility that
is 188 times ,reater than the mar)et. If a stoc) had a beta of 188, it would be
expected to ,o to 8 on any decline in the stoc) mar)et. If you e(er see a beta of
o(er 188 on a research site it is usually the result of a statistical error, or the ,i(en
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stoc) has experienced lar,e swin,s due to low li.uidity, such as an o(er-the-
counter stoc). !or the most part, stoc)s of well-)nown companies rarely e(er ha(e
a beta hi,her than $.
3h9 3e Shoul5 &no8 3hat Beta Is
&re you prepared to ta)e a loss on your in(estments? ;any people are not and
therefore opt for in(estments with low (olatility. :ther people are willin, to ta)e
on additional ris) because with it they recei(e the possibility of increased reward.
It is (ery important that in(estors not only ha(e a ,ood understandin, of their ris)
tolerance, but also )now which in(estments match their ris) preferences.
&nd, by usin, beta to measure (olatility, you can better choose those securities
that meet your criteria for ris). In(estors who are (ery ris) a(erse should put their
money into in(estments with low betas such as utility stoc)s and Treasury bills.
Those in(estors who are willin, to ta)e on more ris) may want to in(est in stoc)s
with hi,her betas.
;any bro)era,e firms calculate the betas of securities they trade and then publish
their calculations in a beta boo). These boo)s offer estimates of the beta for almost
any publicly-traded company. The problem is that most of us don>t ha(e access to
these bro)era,e boo)s, and the calculation for beta can often be confusin,, e(en
for experienced in(estors.
3arnings about Beta
The most important ca(eat for usin, beta to ma)e in(estment decisions is that beta
is a historical measure of a stoc)>s (olatility. 'ast beta fi,ures or historical
(olatility does not necessarily predict future beta or future (olatility. In other
words, if a stoc)>s beta is 2 ri,ht now, there is no ,uarantee that in a year the beta
will be the same. :ne study by 9ene !ama and 3en !rench called IThe "ross-
6ection of Expected 6toc) %eturnsI *published in 1112 in the Journal of Finance-
on the reliability of past beta concluded that for indi(idual stoc)s past beta is not a
,ood predictor of future beta. &n interestin, findin, in this study is that betas seem
to re(ert bac) to the mean. This means that hi,her betas tend to fall bac) towards 1
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Internal Assignment Financial
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and lower betas tend to rise towards 1.
The second ca(eat for usin, beta is that it is a measure of systematic ris), which is the ris)
that the mar)et as a whole faces. The mar)et index to which a stoc) is bein, compared is
affected by mar)et-wide ris)s. 6o, as beta is found by comparin, the (olatility of a stoc)
to the index, beta only ta)es into account the effects of mar)et-wide ris)s on the stoc).
The other ris)s the company faces are firm-specific ris)s, which are not ,rasped fully in
the beta measure. 6o, while beta will ,i(e in(estors a ,ood idea about how chan,es in the
mar)et affect the stoc), it does not loo) at all the ris)s the company alone faces.

11
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Internal Assignment Financial
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1$$ 0 $!(# $A!
"ash reser(e %atio *"%%- is the amount of funds that the ban)s are re.uired to par) with
the %+I. If the central ban) decides to increase the "%%, the a(ailable amount with
the ban)s comes down. The %+I resorts to "%% tool to drain out excess money out of the
system. "%% is under section $2 of %+I &ct, 11$.
"ommercial ban)s are re.uired to maintain with the %+I an a(era,e cash balance,
the amount of which shall not be less than 3% of the total of the Net Deman5 an5 ime
.iabilities *ND.+/ on a fortni,htly basis and the %+I is empowered to increase the
rate of "%% to such hi,her rate not exceedin, 28Q of the 0?T5.
In terms of 6ection $2*1&- of %+I &ct, 11$, the 6cheduled "ommercial +an)s are
re.uired to maintain, in addition to the balances prescribed under 6ection $2*1- of the &ct,
an additional a(era,e daily balance, the amount of which shall not be less than the rate
specified by the %+I in the notification published in the 9a#ette of India, such additional
balance bein, calculated with reference to the excess of the total of the 0?T5 of the ban)
as shown in the return referred to in section $2*2- of the %+I &ct, 11$ o(er the total of its
0?T5 at the close of the business on the date specified in the notification.
5atest "%% is $.2A *WE! 8 0o(ember,2812- as announced by %+I on 8 :ctober, 2812
1om4utation o7 Deman5 an5 ime .iabilities
5iabilities of a ban) may be in the form of demand or time deposits or borrowin,s or
other miscellaneous items of liabilities. 5iabilities of the ban)s may be towards ban)in,
system *as defined under 6ection $2 of %+I &ct, 11$- or towards others in the form of
?emand and Time
deposits or borrowin,s or other miscellaneous items of liabilities. %eser(e +an) of India
has been authori#ed in terms of 6ection $2 *1"- of the %+I &ct, 11$ to classify any
particular liability and hence for any doubt re,ardin, classification of a particular liability,
the ban)s are ad(ised to approach %+I for necessary clarification.
Maintenance o7 1$$ on 5ail9 basis
With a (iew to pro(idin, flexibility to ban)s in choosin, an optimum strate,y of holdin,
reser(es dependin, upon their intra period cash flows, all 6cheduled "ommercial +an)s,
are re.uired to maintain minimum "%% balances up to P8 per cent of the total "%%
re.uirement on all days of the fortni,ht with effect from the fortni,ht be,innin,
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Internal Assignment Financial
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?ecember 27, 2882. If any 6cheduled "ommercial +an) fails to obser(e the minimum
le(el of "%% on any dayHs durin, the rele(ant fortni,ht, the ban) will not be paid interest
to the extent of one fourteenth of the eli,ible amount of interest, e(en if there is no
shortfall in the "%% on a(era,e basis.
(a9ment o7 interest on eligible cash balances maintaine5 b9 S1Bs 8ith $BI un5er
1$$
i- &ll 6cheduled "ommercial +an)s are paid interest on all eli,ible cash balances
maintained
with %+I under pro(iso to 6ection $2 *1- and 6ection $2 *1&- of the %+I &ct, 11$, at
+an) %ate from the fortni,ht be,innin, 0o(ember , 2881. The rate of interest on "%%
balances has been lin)ed to +an) %ate as announced by %+I from time to time
ii- The 6cheduled "ommercial +an)s were paid 188 per cent interest on "%% balances on
receipt of the .uarterly interest claim statements in a prescribed proforma. !rom the
month of &pril 288 onwards, 6cheduled "ommercial +an)s were paid interest on "%%
balances on monthly basis on receipt of interest claim statements. With effect from &u,ust
288$, interest on "%% balances would be paid without obtainin, interest claim statements
from 6cheduled "ommercial +an)s.
iii- The amount of interest payable at +an) %ate is to be wor)ed out on the eli,ible
portion of "%% balances for a period of 1$ days. In case the "%% balances held with %+I
is less than the amount re.uired to be maintained for any of the fortni,hts, eli,ible interest
will be paid for that defaulted fortni,ht only after wor)in, out cost of shortfall at the rate
of 2A per cent per annum and subtractin, the amount so wor)ed out from interest payable
amount.
$e4o $ate
The rate at which the %+I lends money to commercial ban)s is called repo rate. It
is an instrument of monetary policy. Whene(er ban)s ha(e any shorta,e of funds they can
borrow from the %+I. &t present %epo rate is 7.88 Q wef 0o(ember, 2812.
& reduction in the repo rate helps ban)s ,et money at a cheaper rate and (ice (ersa. The
repo rate in India is similar to the discount rate in the 26 ?iscount rate is at which a
central ban) repurchases ,o(ernment securities from the commercial ban)s,
dependin, on the le(el of money supply it decides to maintain in the country>s
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Internal Assignment Financial
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monetary system. To temporarily expand the money supply, the central ban) decreases
repo rates *so that ban)s can swap their holdin,s of ,o(ernment securities for cash-, to
contract the money supply it increases the repo rates. &lternati(ely, the central ban)
decides on a desired le(el of money supply and lets the mar)et determine the appropriate
repo rate.
?urin, the period between ?ecember 1112 and ;arch 111A, the %eser(e ban) undertoo)
repos initially for one , two or wor)in, days co(erin, fi(e days in a wee)ly cycle, which
was later replaced by a 1$ days cycle co(erin, the reser(e ma)e-up period. The repos
were discontinued after ;arch 111A due to a lac) under ti,ht li.uidity conditions and
resumed in early 111P. %epos of -$ days cycle were re-introduced, as shorter period
repos pro(ide ,reater maneu(erability to the %eser(e +an) in decidin, the .uantum of
li.uidity to be absorbed or in/ected dependin, upon the supply and demand conditions.
The repo rates, apart from reflectin, li.uidity conditions, pro(ide a floor for the o(erni,ht
call money rates.
To control the stron, inflationary pressures in the economy, %+I has relied basically in
repo rate and re(erse repo rate in recent times. This can be understood by the fact that
o(er the period ;arch 2818 to ;ay 2811, these rates were raised as many as nine times.

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